Market Based Policy 1 Corrective Taxes and Subsidies

Instead of regulating behavior in response to an externality, the government can use market-based policies to align private incentives with social efficiency. For instance, as we saw earlier, the government can internalize the externality by taxing activities that have negative externalities and subsidizing activities that have positive externalities. Taxes enacted to deal with the effects of negative externalities are called corrective taxes. They are also called Pigovimt taxes after economist Arthur Pigou (1877-195M), an eariv advocate of their use. An Ideal corrective tax would equal the external cost from an activity with negative externalities, and an ideal corrective subsidy would equal the external benefit from an activity with positive externalities.

Economists usually prefer corrective taxes to regulations as a way to deal with pollution because they can reduce pollution at a lower cost to society. To see why, let us consider an example.

Suppose that two factories—a paper mill and a steel mill—are each dumping 500 tons of gkip into a river each year. The EPA decides that it wants to reduce the amount of pollution It considers two solutions:

• Regulation: The EPA could tell each factory to reduce its pollution to 300 tons of gkip per year.

• Corrective tax: The F.PA could levy a tax on each factory of S50/WCI for each ton of glop it emits.

The regulation would dictate a level of pollution, whereas the tax would give factory owners an economic incentive to reduce pollution- Which solution do you think is better?

Most economists prefer the tax. To explain this preference, they would first point out that a tax is just as effective as a regulation in reducing the overall level of pollution. The EPA can achieve whatever level of pollution it wants by scning the tax at the appropriate level. The higher the tax, the larger the reduction in pollution If the lax is high enough, the factories will close down altogether, reducing pollution to zero.

Although regulation and corrective taxes are both capableof reducing pollution, the lax accomplish« this goal more efficiently. The regulation requires each factory to reduce pollution by the same amount. An equal reduction, however, is not necessarily the least expensive way to dean up the water. It is possible that the paper mill can reduce pollution at lower cost than the steel mill. If so, the paper mill would respond to the tax by reducing pollution substantially to avoid the tax. whereas the steel mill would respond by reducing pollution less and paying the tax.

In essence, the corrective tax places a price on the right to pollute. Just as markets allocate goods to those buyers who value them most highly, a corrective tax allocates pollution to those factories that face the highest cost of reducing it. Whatever the level of pollution the EPA chooses, it can achieve this goal at the lowest total cost using a tax.

Hconomists also argue that corrective taxes are better for the environment. Under the command-and-control policy of regulation, the factories have no reason to rcducc emission further once they have reached the target of 3(H) tons of gk>p. By contrast, the tax gives the factories an incentive to develop cleaner technologies because a cleaner technology would reduce the amount of tax the factory has to pay.

Corrective taxes are unlike most other taxes. As we discussed in Chapter 8. most taxes distort incentives and move the allocation of resources away from the social optimum. The reduction in economic well-being—tlu! is, in consumer and producer surplus—exceeds the amount of revenue the government raises, resulting in a deadweight loss. By contrast, when cxlemalitics are present, society also cares about the well-being of the bystanders who are affected. Corrective taxes alter incentives to account for the presence of externalities and thereby move the allocation of resources closer to the social optimum. Thus, while corrective taxes raise revenue for the government, thev also cnhance economic efficiency.

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Responses

  • lidya rezene
    How do regulation and corrective taxes and subsidies differ from each other ?
    8 years ago

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